Academic journal article Economic Inquiry

New Estimates of the Optimal Tax on Alcohol

Academic journal article Economic Inquiry

New Estimates of the Optimal Tax on Alcohol

Article excerpt


Over the past decade, federal taxes on alcoholic beverages have been increased twice, first in 1984 and again in 1990, to raise revenue and reduce the federal deficit. Many states also increased alcohol taxes, again usually prompted by revenue concerns. The recent experience is in sharp contrast with the long-term trend of declining real alcohol taxes, due to inflation eroding the real value of excise taxes fixed in nominal terms. Figure 1 shows the average tax rate on alcoholic beverages, including federal, state, and local taxes.(1) The average tax rate was over 50 percent of the net-of-tax price (that is, the price exclusive of taxes) in 1954, but declined to below 25 percent by the beginning of the 1980s. Nominal increases during the 1980s only served to keep the real tax rate roughly constant at slightly above 20 percent.

Aside from revenue concerns, taxing alcohol is possibly justified on Pigovian grounds because of the external costs associated with excessive alcohol consumption. The most dramatic external costs are the thousands of non-drinkers killed by drunk drivers each year. Most of the remaining external costs stem from the adverse health effects of heavy drinking, which create medical and other costs that are only partly borne by the drinker. In light of the external costs, a number of economists have supported alcohol tax increases, some via a petition to Congress. Several recent empirical estimates suggest that the optimal tax rate is about double the current rate, but the range of estimates has been extremely wide, from 19 to 306 percent.(2)

In this paper I use a new data set to estimate most of the key determinants of the optimal alcohol tax rate, in an attempt to narrow the range of plausible estimates. Choosing the optimal alcohol tax involves balancing the deadweight welfare losses taxation creates as moderate drinking falls with the welfare gains created as socially costly heavy drinking is reduced. The relative price elasticities of the demand for moderate and heavy drinking are therefore key determinants of the optimal tax rate, but empirical evidence on these elasticities is limited.(3) An important contribution of this paper is to estimate separately the price elasticities of the demand for moderate drinking and the demand for heavy drinking. The demand for heavy drinking is estimated to be at least as price elastic as the demand for moderate drinking, implying there is considerable scope for alcohol taxation to improve social welfare.

As a benchmark, the empirical results imply that the optimal tax rate is over 100 percent of the net-of-tax price, higher than many other recent estimates, and about five times the current average rate. However, in the framework used alcohol taxation is a second-best solution to some of the social costs created by heavy drinking. An important question is the extent to which the optimal tax would fall if other, more direct policies were also used. The analysis therefore turns to estimating the optimal tax rate under alternative policy scenarios.

In this and other studies, a large portion of the external costs of heavy drinking actually stem from drunk driving. The most direct policy response is to increase the certainty and severity of drunk driving penalties. If penalties for drunk driving were certain and severe enough to force drunk drivers to see the full social costs of their actions, the estimated optimal alcohol tax rate falls to 42 percent, less than half the benchmark estimate and much closer to current rates. This suggests that stricter drunk driving laws deserve consideration as policy substitutes for alcohol taxation.

This paper also incorporates imperfect consumer information as an additional reason alcohol taxation may be a desirable second-best policy.(4) Heavy drinking has serious health effects, but many drinkers are unaware of at least some of these (for evidence on this point, see Kenkel [1991]). …

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